Stablecoins: an economic perspective

There has been a lot of buzz lately discussing the concept of stablecoins — a cryptocurrency which doesn’t suffer from high price volatility like Bitcoin.

For the most part, they focus on the technical challenges of implementing a peg in a cryptocurrency. In a nutshell, a peg secures the price of a currency as closely as possible to the price of a different currency — in the case of nearly all cryptos, to the US dollar.

At first glance, this seems interesting. Thanks to the efforts of the US federal reserve, the dollar functions fairly well as a store of value, medium of exchange and unit of account — the 3 critical features of a successful currency. If a decentralized crypto could be pegged to the dollar, then we would be able to enjoy the best of both worlds, right?

Sadly, no.

Every single project out there that has tried this has either not been remotely decentralized (I’m looking at you Tether…) or has suffered from other shortcomings. But beyond this, there is an inherent flaw in pegging cryptos to the dollar.

This flaw is an, albeit indirect, reliance on a central bank. This goes against everything Bitcoin stands for. The entire beauty of Bitcoin and other decentralized cryptocurrencies is the lack of need for banks. That is pretty much the entire damn point.

There are also some hot projects out there that propose a price peg to other cryptos (or to an index of cryptos). This too is problematic. The peg will never be as stable as (trustworthy) FIAT currencies because it’s inherently tied to volatile cryptos.

The big question in my eyes is, is it possible to create a stablecoin that is a store of value, medium of exchange and unit of account without a peg or reference of any sort to FIAT currency. To answer this, we need to understand how FIAT currency works. Then we can just recreate those same features in a decentralized way. Easy peasy…

Let’s dive in.

The dollar is a great medium of exchange. It has a massive supply and there is a strong (centralized) system in place which makes it easy to make transactions. It’s also stable enough in the short term for people to feel comfortable exchanging it for goods and services.

The dollar is not however a very good store of value in the long term. Everyone knows that 100 years ago the dollar was worth far more than it is today. This is the result of a constantly growing money supply. The federal reserve issues new treasury bonds and voila, new money is created. Private banks can then lend those funds according to the fractional reserve system at a 10:1 ratio. This means that for every dollar created by the fed, 10 dollars are potentially created in the economy. More details can be found here.

How does the monopolistic federal reserve know when to create more money? The truth is, they don’t really know. Regulators do their best to predict how the economy is going to behave and create new money according to expected demand. But the economy is complicated, so it should not come as a surprise that there are many contradictory opinions and theories.

Lastly, the unit of account part is relatively simple. People are willing to measure the value of real goods and services using dollars. The moment they are no longer willing to do so, the dollar wont be a unit of account any longer. It’s simply a matter of trust.

Let’s move the conversation back to crypto, but use the economic definitions above to try and understand Bitcoins strengths and weaknesses.

Bitcoin is already an extraordinary store of value. There is a fixed supply of 21 million Bitcoin and therefore, as demand for Bitcoin increases over time, its price will necessarily increase as well. While Bitcoin may suffer from short term volatility, in the long term it’s price will always increase. This is why Bitcoin is often called digital gold.

However Bitcoin falls short as a medium of exchange for exactly the same reason — fixed supply. Short term volatility and long term price increases demotivate consumerism. It’s better to HODL than use your Bitcoin.

As a unit of account, Bitcoin is perfectly effective because we have trust in it. It’s possible to use Bitcoin to measure the cost of goods and services, and many efforts are being made to expand the amount of things you can buy with Bitcoin.

In my opinion, the stablecoin that will eventually grow in popularity will succeed in mimicing the money supply and leverage concepts used by FIAT, but in a decentralized way. This is an enormous challenge. It’s not readily apparent how such a thing could even be possible. Perhaps by utilizing some sort of p2p credit structure? How would money supply decisions be made? According to which money supply policy?

Finding a solution for these questions is one of the most pressing field of research in the crypto space today. If done, it would mean the evolution of crypto from a strong store of value to a bonafide replacement for FIAT currency, and could even render the entire traditional banking system obsolete.